China’s Surprise Rate Hike and How it Could Affect Commodities, Currencies

http://www.dailyfx.com/forex/fundamental/article/special_report/2010/12/27/China_Surprise_Rate_Hike_Commodities_and_Currencies.html

Following a failed 3-month Bill auction on Friday which sent equity markets across Asia lower, the People’s Bank of China announced that deposit and lending rates would be raised. The increase is similar to the rate hike employed by the PBoC in October: the deposit rate holds at 36 basis points; deposit rates for 3-months and greater increased by approximately 30 basis points; lending rates raised by approximately by 25 basis points; and the 1-year rates for the deposit rate and lending rate are raised in lockstep, up 25 basis points each. These changes apply to the reserve requirement ratio for banking institutions.

The 25 basis points increase was the second such hike in 2010: the first occurred in October, which was the first time the PBoC raised such rates in three years. The hawkish action has had little impact on the market on Monday, as after the Central Economic Working Conference a few weeks back, it was expected that the PBoC would raise rates in the near future – nonetheless, there have been murmurs that the PBoC will implement two or three more such hikes by the end of 2011. Why though? The Federal Reserve’s policy of quantitative easing has caused additional liquidity injected into the money supply to be exported overseas, where foreign markets have higher rates of returns on financial assets. Accordingly, the additional money invested in these markets, such as China, has boosted inflation rates unwillingly; China’s Consumer Price Index has been positive since November 2009, and according to the most recent CPI release on December 11, 2010, inflation outpaced expectations by growing at a 5.1 percent; the PBoC aims to maintain an inflation rate of 3 percent. The PBoC effort is a clear confirmation that inflation is a real concern, and thus rate hikes will be necessary to keep economic growth on a stable trajectory.

The move puts Federal Reserve Chairman Ben Bernanke and Secretary of the Treasury Timothy Geithner on quite different paths in regards to their respective, long-term objectives: ensure credit flows to the economy; and have an appropriate exchange rate between the Renminbi and the Dollar (the Yuan is widely-viewed as undervalued). First, as quantitative easing continues to be a policy tool of the Federal Reserve, credit will flow to wherever it will find borrowers. Now, as investment desire dims slightly in China, investors may see that commodity prices here in the United States increase at a quicker pace. Specifically, this could prove to be a strong bullish fundamental for gold, as the yellow metal has typically been viewed as a hedge against inflation risks – which, are ever present in China, and hopefully soon, here in the United States (as per Fed Chairman Bernanke’s rhetoric). On the other hand, for Secretary Geithner, the rate hike will allow the Yuan to appreciate further against the Dollar. The Yuan has already gained approximately 4.2 percent against the Greenback in 2010, and a similar if not greater appreciation is expected in 2011. Should the rate hikes of October and December 2010 fail in curbing inflation in China, additional rate hikes will be implemented, forcing a speedier appreciation of the Yuan against the Dollar.

Written by Christopher Vecchio, DailyFX Research

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